End of an era


In August 2007 the repo market in the US became dislocated. Banks become worried about the extent to which their counterparties held sub-prime debt and short-term inter-bank rates spiked overnight. For the next 13 months the extent of toxic waste in structured products became more evident and some of the biggest names in the industry were clearly in trouble. Excessive leverage across the whole system became evident. House prices started to fall in the big developed countries. Government treasury heads and central bankers cajoled bankers into hurried mergers, but to no avail for Lehman Brothers, which collapsed in September 2008.

Banks stopped transacting with other banks. The huge market in debt assets simply closed down. This was unprecedented.

Mohamed El-Erian, CEO of PIMCo, explained the situation using a fastfood drive-through analogy. The customer is hungry and drives up to the window, ordering a hamburger. But the assistant is not convinced that she will pay, so he cannot process her order. The customer will not pay in advance as she is worried that the outlet will close down before she gets her hamburger. So she goes hungry and the chain goes out of business. This was how it was in the interbank market in 2008. With massive support by national governments, it is gradually recovering.


Opinion divided


These rescues meant that governments became the effective owners of massive amounts of problematic debt. Moreover, they engaged in aggressive fiscal stimulation to replace the collapse in private consumption that occurred as households attempted to deleverage. This fiscal stimulus continues today and has created high government debt in the world’s developed markets.

Economists hold differing views over the usefulness of this fiscal stimulus. Some think that the replacement of private consumption with government spending is the only thing keeping many major economies from falling into deep recession. They are desperate to avoid a repeat of Japan’s decades of economic malaise. In the other camp are those that believe that government spending is wasteful. They wish to bring down government debt that will need to be paid for by future generations in the form of high taxes and/or inflation.

But when the holders of government debt become sufficiently worried about its repayment or debasement through inflation, they might require higher interest rates as bonds mature and need to be refinanced.

This has yet to happen for some of the largest developed countries, where the activities of central banks has kept rates very low. Bondholders are receiving a poor return for the risk that the real value of their assets will be eroded by inflation.

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